Fresh Ideas for Consideration
Most finance gurus refer to a general rule of thumb in determining whether or not to prepay some or your entire mortgage… compare the interest rate on your mortgage with the expected rate of return on your investable assets. If your mortgage rate exceeds the rate you can earn on your investable assets consider paying down your mortgage and vice versa. While this analysis still holds true, most investors feel more uncertain about their expected rate of return following unprecedented turbulence in the capital and credit markets.
In periods of good economic conditions and appreciating capital markets, most people feel comfortable maintaining their mortgage payments and deploying their investable cash in the stock and securities markets. The S&P 500 index generated average annualized returns of approximately 13% during the five year period ending December 31, 2007. If you maintained a mortgage with a 6% interest rate during this period it is safe to conclude you were better off deploying excess cash in the stock market versus paying down the principal on your mortgage. However, following a decline of 38% in the S&P 500 index in 2008, most people found themselves reconsidering their investment strategies and best use of available cash.
The following are some factors you might consider in your decision to pay off some or your entire mortgage balance before maturity.
Loan amortization & payoff timing
On a standard 30 year mortgage loan, the bulk of the interest payments occur during the first 10 years of the loan. Let’s say you have a 30 year $500,000 fixed rate mortgage at 6%. Your monthly mortgage payment is $3,000. In year 1, approximately 85% of each mortgage payment is attributable to interest. In year 28, approximately 85% of each mortgage payment is attributable to principal. $580,000 of interest will be paid if the loan is held to maturity. Approximately 50% of the total interest is paid after the first 10 years of the mortgage. Therefore, you will save the most interest to the extent you can make additional principal payments during the early life of the loan. Consistently making an additional payment of $100/month on this loan reduces your overall interest by $60,000 and the life of the loan to a little over 27 years.
Taxes
If you itemize your deductions you can deduct interest relating to $1M of qualified mortgage indebtedness. With the availability of easy credit over the past 5-10 years, the IRS has taken a closer review of taxpayer mortgage interest deductions in light of the various tax limitations. If you live in California and subject to the highest marginal tax bracket, every dollar of mortgage interest paid saves you approximately 45 cents in income tax. With tax rates expected to rise over the next several years, the deduction could become even more valuable.
Inflation
Most economic experts believe the United States will experience a period of heightened inflation and higher interest rates over the next several years following a period of increased government spending. If you believe mortgage rates will rise to 8-10% or higher over the next several years you would likely achieve a higher rate of return in fixed income securities instead of using this cash to pay down your mortgage.
Home prices
One in five homeowners is “underwater” on their mortgage. That is, the principal balance on their mortgage is higher than the value of their home. If you plan on selling your home before establishing equity it probably doesn’t make sense to make additional principal payments on your home.
Credit card debt
Higher interest rate debt should be paid down before your mortgage. If you’re carrying credit card debt at 12%, for example, every dollar you pay off earns you an instant 12% return on your money. You should consider paying off your non-deductible credit card debt before your mortgage in nearly all situations.
Retirement plans
You were hopefully sitting down the last time you opened your 401(k) statement. Many American workers have experienced unprecedented losses in their 401(k) accounts, and for most people it’s counter intuitive to contribute more hard earned money to their retirement accounts in this stock market environment. However, if you are more than 5-10 years away from retirement you should consider funding your 401(k) accounts to the extent you can afford it. At the very minimum, you should contribute enough to receive the full company match…it’s free money and an instant return on your investment.
Emotion
Many Americans have experienced increased levels of anxiety and uncertainty during the economic recession. Mounting unemployment combined with 401(k) and home value declines have forced many Americans to tap their emergency funds. Once you pay off your mortgage you can’t get the cash back unless you apply for a reverse mortgage or home equity line of credit (probably at higher rates). Most people would prefer to maintain a $500,000 mortgage with $500,000 in the bank versus no mortgage and no cash in the bank.
We have touched on only some of the considerations involved in paying off your mortgage early. You should review your financial situation with your CPA or finance professional to determine any other factors that may play a role in this important decision.